The Impossible Trinity : Competitive Markets, Free Entry, and Efficiency

When policy depends on popular support, it is unfeasible to obtain allocative efficiency under competitive markets and free entry. We derive that this fundamental impossibility result holds because policy as well as prices respond to factor allocations. In our baseline model, free entry regards occupational choice while the policy instrument is taxation. Workers in occupations whose services are in high demand by the government will favor high taxes. Workers in occupations whose services are in low demand by the government will favor low taxes. Then, the socially efficient size of the public sector cannot be supported in equilibrium, as endogenous policy rewards entry to the sector where workers are abundant. We generalize our theory, and show how our impossibility result extends beyond the baseline model. We also discuss how departing from competitive markets may affect equilibrium outcomes. Our analysis highlights the importance of feedback loops between allocations, policy, and prices